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Are You Making Money on Purpose?

There's a certain amount of luck involved in investing. Nobody can accurately predict the future all the time, yet every single solitary cent of any company's stock price is based on some sort of prediction of what that company will do in that unknown future.

You could get lucky in a good way, and a stock you buy could skyrocket shortly after you hand over your cash to pick up some of its shares. Or you could get lucky in a bad way, and discover that what you thought was a well-informed investment turns out to be the next Chinese scam on its way to bankruptcy.

Or you can reduce the impact of luck While luck can't be completely eliminated, you can follow a time-tested approach to reduce its impact and increase the chance that the money you earn from investing, you earn on purpose. This approach traces its roots to the heels of the Great Depression and Benjamin Graham, the father of Value Investing and the man who taught Warren Buffett how to invest.

The three parts to this Graham-inspired strategy are straightforward on their own, but they really gain their power when all three are used together. Those keys to investing success are:

Dividends

Valuation

Diversification

Here's why each matters, and how they work together.

Dividends Dividends are cash payments made to investors to directly compensate them for the financial risks they're taking for owning stock. Not every company pays a dividend, but once a company starts paying a regular dividend, it represents not only cash in investors' pockets, but also an incredibly clear signal of the company's prospects.

Take General Electric (NYSE: GE) as a prime example. The company was once incredibly protective of the dividend that it had maintained for decades and increased annually for over 30 years. When its overexposure to subprime debts during the financial crisis tripped up its own operations, one of the earliest public signals of just how bad the damage was came from the company's dividend. After decades of clockwork annual raises, it held the dividend steady for six quarters, before finally cutting it.

Similarly, electric generating company Exelon (NYSE: EXC) tried to protect its at-risk dividend before finally succumbing to a cut. The saga unfolded in public over several months, as investor speculation and company statements hashed out whether the payment could be maintained, and under what circumstances.

Dividends may not be guaranteed payments, but in both of these cases, company management made it clear that they know investors watch their dividends and carefully analyze changes to policy. That both companies somewhat telegraphed their difficulties via their dividends shows how those payments can provide not only direct financial rewards but also powerful signals of what's really happening.

Valuation One strategy Benjamin Graham favored was buying stocks trading below their net current asset values. His theory was that any surviving company should be worth at least that much, and any dying company should be convertible into somewhere in the neighborhood of that amount of cash when liquidated.

While that strategy worked well for him when he invented it, in these days of ultrafast computerized trading, the companies that trade at those levels generally do so for really good reasons. Take the giant banks Citigroup (NYSE: C) and Bank of America (NYSE: BAC) . Looking just at their market prices and tangible asset values, they appear to be incredible bargains:

Company

Market Capitalization

Net Tangible Asset Value

Bank of America

$129.7 billion

$161.6 billion

Citigroup

$132.8 billion

$154.9 billion

Source: Yahoo! Finance as of Feb. 16, 2013.

Yet in the topsy-turvy world that is bank accounting, the largest asset on their books is other people's and business' debts: mortgage loans, business loans, credit card loans, etc. For those assets to really be worth their book values, the borrowers behind those debts need to reliably make their payments. It wasn't that long ago that both of these companies nearly imploded when more people than expected stopped paying on their mortgages, triggering the recent financial crisis.

Still, whether it's looking at tangible asset values or some other method of estimating a company's true worth, looking for legitimate value can reduce your risk of overpaying for the companies you buy.

Diversification Since dividends aren't guaranteed and valuation methods can only protect you so far if a company falters, you need to diversify your holdings across industries in order to spread out those risks. Diversification doesn't eliminate the risk of a company going bad, but it does reduce the impact of any one failure on your overall portfolio. The upside of diversification is that protection, but the downside is that it also mutes the gain you get if any one of your companies dramatically exceeds your expectations.

Dividends and valuation are the tools that can help you find companies worth owning based on the real money they're generating and paying to shareholders. Diversification is the tool that protects you when something goes wrong. Use all three together, and you have a strategy centered on making money on purpose. Isn't that better than throwing your money at the market and hoping you get lucky?

Chuck Saletta owns shares of General Electric and has an open options position in Bank of America. The Motley Fool recommends Exelon. The Motley Fool owns shares of Bank of America, Citigroup Inc , and General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Comments from our Foolish Readers

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Ben Graham bought extreme value. I am not saying you can't find extreme value today but I believe it was easier to back then. Why? Information. Back then you had to write a company a letter and have them mail you their financial information. Now anybody can look that same information up instantly online. Plus the financial services industry is bigger today and there are lots of sharks out there looking for the best deals.

Buffet was a Graham disciple but didn't look for that same extreme level of value. He even once said, "you are better off buying a great company at a fair price than a fair company at a great price". Graham didn't care as much about the quality of the company, he just wanted to buy it for so cheap that even if the company did fold he'd make out ok, if things turned around he'd make a pretty penny.

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Chuck Saletta has been a regular Fool contributor since 2004. His investing style has been inspired by Benjamin Graham's Value Investing strategy. Chuck also can be found on the "Inside Value" discussion boards as a Home Fool.